3rd Port Shipment and Economic Substance Regulation
What is 3rd Port Shipment?
3rd Port Shipment, is a supply chain management method in which the business does not keep goods in stock but instead transfers its customer's orders and shipment details to either the manufacturer, another retailer, or a wholesaler, who then ships the goods directly to the customer. As in business, the majority of retailers make their profit on the difference between the wholesale and retail price.
There are various other names used for such trade example “Drop Shipment” “Foreign-to-Foreign shipment”, “Triangle Shipment” etc. For the benefit of all, in this article we will use the term as “3rd Port Shipment”.
What are the benefits of 3rd Port Shipment?
Considering 3rd Port Shipment is managed by a UAE company or distributor:
(a) it reduces supply chain costs;
(b) decrease transit time or transportation time from the country of origin to country of destination;
(c) Optimize the supply chain while dealing with one entity, example in this case, UAE entity is a procurement centre for efficient network.
What if UAE company is the related entity of manufacturer / supplier, will this attract Economic Substance Regulation?
Let’s revisit the Economic Substance regulation, with relevant / reference points provide below:
Extract from - Cabinet of Ministers Resolution No. 31 of 2019 Concerning ESR, provides definition for “Distribution and Service Centre Business as below”:
Distribution and Service Centre Business: any of the following businesses:
(a) purchasing from a Foreign Connected Person and importing and storing in the State: component parts or materials for goods; or goods ready for sale, and reselling such component parts, materials or goods outside the State.
(b) providing services to Foreign Connected Persons in connection with a business outside the State.
Commentary:
As per definition, "3rd Port Shipment" may not be attracted to the point (a) since “storing in the state” is not satisfied.
Extract from - The UAE Economic Substance Regulations Relevant Activities Guide
3.9 Distribution and Service Centre Business
A “Distribution and Service Centre” Business refers to two distinct activities that are covered under one “Relevant Activity” heading.
A Licensee is considered engaged in a “Distribution Business” if the Licensee purchases raw materials or finished products from a foreign group company, and distributes those raw materials or finished goods.
A Licensee is considered engaged in a “Service Centre Business” if it provides consulting, administrative or other services to a foreign group company, and those services are in connection with the foreign group company’s business outside the UAE.
Licensees that only purchase goods from or distribute goods to third parties are not considered engaged in a Distribution Business. Likewise, Licensees that are engaged in the business of providing services to third parties are not considered as carrying on a “Service Centre Business”.
Commentary:
As per Activity Guide, there is no reference to the point related to “storing in the state”, and hence purchases of goods from a foreign related party, and onward distribution gets covered. It further gets elaborated that the “Licensees that only purchase goods from third parties are not considered engaged in a Distribution Business”.
Now the question is... can a guide supersede the Cabinet of Ministers Resolution?
Article 6 of the "resolution", states that:
6. The Competent Authority shall issue guidance on how the Economic Substance Test may be met, including without prejudice to the generality of the foregoing, any expression used in this Article for the purpose of that test, including the meaning of “adequate”.
7. Regard must be had to any guidance under Clause 6 of this Article concerning the interpretation of any expression.
8. The Competent Authority may revise guidance issued under Clause 6 of this Article from time to time and a reference to guidance includes a reference to revised guidance.
Concluding Comments:
As per intent of the law and primary read, activity performed under the “3rd Port Shipment” may be classified under the head Distribution and Service Centre” Business.
Model adopted by entity based in UAE may be envisaged as of providing services for the foreign related party i.e. providing services to Foreign Connected Persons in connection with the business outside the state, by facilitating:
1. Order booking.
2. Stock / goods movement management, etc.
3. Managing the payment.
4. Administrative procedures of invoicing / BL/ etc.
There may be further guidance note’s, on the subject from the competent authorities. Till time these are clarified, we need to ensure that the intent of the regulation is also read with the verbatim.
CEO & Founding Partner at CLA Emirates [Formerly ECAG- EMIRATES CHARTERED ACCOUNTANTS GROUP]
4 年Excellent analysis Rajiv. In line with the session we had in ICAI Chapter earlier. Keep writing
Manager - Finance at Adani Group
4 年Insightful Interpretation. A typical Rajiv Hira article it is!! I believe besides thinking about “intent vs. verbatim” considerations, we should also look into broader practical implications of the judgment that we make in this scenario. If purchase of goods from foreign connected person (FCP) with onward sale by UAE entity is to be classified as “service center” activity, following practical issues come into the question: -> Firstly, what will be the amount of income from relevant activity in such case? Usually, such transactions may have sales value of say 10 million AED but profit margin may be just say 100 thousand AED. Saying that the UAE entity is providing “services” to the tune of AED 10 million to its FCP will be too extreme interpretation of law. If it is providing transaction facilitation service to its FCP, their intended consideration is only the profit margin of AED 100 thousand, which is a sort of implicit sales commission. We should note that our stand on 10 million vs 100 thousand interpretation can vastly change what would be “adequate and appropriate” resources to justify economic substance of the transaction. And what if this transaction genuinely results into loss where purchase and sales prices are justified as per transfer pricing norms? Just like VAT laws do not define "Supply", ESR laws do not define "Income". -> Secondly, if we are buying goods from our FCP, we need not have specialized sourcing skills that we would otherwise require while buying goods from an unrelated supplier. Our comfort level while buying from our group entity would be much better compared with unrelated supplier. Judgement on adequacy of staff in terms of qualification and experience will become quite ambiguous, subjective and debatable. -> Thirdly, most companies would have obtained some sort of trade finance facilities from UAE banks by negotiating these trade documents with counter parties. Now if we take a stand that we are acting only as a transaction facilitator for our group company, we are contradicting the stand that we took while availing trade finance facilities. This can potentially drag us into more serious situation of banking non-compliance. It is very much an intent of BEPS action plan to include third port shipment within its ambit. But it can only be included as Distribution of goods activity; perhaps not as Service Center activity. Also, it is for the signing governments to implement the BEPS action plan and not the individual entities. For a UAE based entity, no other document is as supreme as the Cabinet Decision of our government. We can safely call this a transaction of trading in goods – both in legal form as well as in substance. Our strongest contentions for this stand will be that: i)??We are possessing valid trade documents ii)?We are assuming risks and rewards of ownership of goods, possibly obtaining marine insurance as well iii)?We are able to negotiate the trade documents and obtain trade finance facilities from banks iv) And of course, cabinet decision specifically mentions “importing and storing the goods in UAE” as a condition to fall within RA, which we are not doing. Specific exclusion should override general inclusion.
Finance Head - RAK Ceramics PJSC? Vice Chairman-Ras Al Khaimah Chapter of The Institute of Chartered Accountants of India ? Strategic Financial Leader driving Corporate Finance Excellence ?
4 年Good analysis and surely agree with your conclusion. From substance perspective and till such time it is clarified, in my view, it is better to report.